In this course, you’ll explore how financial statement data and non-financial metrics can be linked to financial performance. Professors Rick Lambert and Chris Ittner of the Wharton School have designed this course to help you gain a practical understanding of how data is used to assess what drives financial performance and forecast future financial scenarios. You’ll learn more about the frameworks of financial reporting, income statements, and cash reporting, and apply different approaches to analyzing financial performance using real-life examples to see the concepts in action. By the end of this course, you’ll have honed your skills in understanding how financial data and non-financial data interact to forecast events and be able to determine the best financial strategy for your organization.

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Aug 19, 2019

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From the lesson

Module 3: Financial Statement Analysis

In this module, you’ll examine a systematic approach to ratio analysis and other common tools of financial statement analysis. You’ll develop an understanding of ratios and liquidity measures so you can accurately assess risk within your organization’s financial activities. You’ll discover different approaches to profitability measures such as Earnings Per Share (EPS), Return on Equity (ROE), and the Dupont Analysis. You will be able to match Return on Assets (ROA) to various types of companies and gain a better understanding of the drivers of ROA. Then, you’ll explore the concepts of sales revenue and different qualities of earnings. By the end of this module, you’ll understand the theoretical basis behind ratio analysis, and be able to employ different ratio analyses and accurately calculate profitability measures for your organization.

Taught By

Richard Lambert

Professor of Accounting

Christopher D. Ittner

EY Professor of Accounting

Transcript

In this video, we're going to provide an overview of ratio analysis or financial statement analysis techniques. So rather than looking at how the financial statements are constructed, we're going to try to talk about a framework to use to try to analyze and interpret what's in the financial statements. As we'll see, knowing something about how the financial statements were constructed is going to be useful in understanding and interpreting the financial statements. So, in addition to giving you tips for how to use financial statement ratios, we also want to talk about some things to avoid doing as well. We're going to apply this in this video to looking at some measures of liquidity and risk for our case company. Now, there are different kinds of ratios that one can calculate that are useful for profitability, versus liquidity, or risk, or other kinds of things. The idea behind all of them though is to try to highlight where we're doing well, and are therefore sources of our competitive advantage, and where we're doing poorly, and therefore represent "red flags", things that we might want to try to correct. Ratios need to be compared to some benchmark. One benchmark is, how are we doing now versus last year? A different benchmark is, how are we doing relative to somebody else? Comparing yourself to competitors is a very important thing to try to do to figure out how you're doing. You can bet that your competitors are trying to compare themselves to you via financial statement analysis techniques as well. A third benchmark is, how are we doing relative to how are we expected to do? The budget or a forecast. It's important to have an idea of the context before you make an interpretation of a ratio. That is, in order to decide is a given number for a ratio good or bad. It's important to understand something about the economic situation that the ratio is being calculated in. Here, putting together your knowledge of the business or the industry, with your knowledge of financial analysis techniques is a synergy that really creates a lot of value. One of the things that we often find when we do financial statement and analysis is that our analysis often generates new questions. Often these are questions that we didn't think to even ask in the first place. So, learning stuff, ask new questions, learn some more stuff, is a cycle that we often repeat in doing financial analysis. Misusing ratios. One of the big problems that we run into is there's no standard definition of ratios. There is no generally accepted accounting principles, no rules, people do things different ways. You want to be careful if you look at a ratio that somebody else has calculated to try to figure out how they've done it or you might risk misusing it. What's the benchmark? Is going to be important as well. If a company changes over time, its ratios are going to change. If a firm strategy that you're comparing yourself to is different than yours, if their capital structure is different, if their product line segments are different, their ratios are going to look different as well. Now that might be the thing that you're actually trying to highlight when you compare yourself to them. But it might also be a difference that's obscuring a difference in the ways that you think you're similar to them from being able to figure that out. Differences in accounting methods can also change the accounting numbers and therefore the ratios that we calculate. Managers know you're calculating ratios, and one of the reasons why they might distort the accounting numbers is to try to distort the ratios that you're calculating. How much debt to equity they have a number they frequently try to distort and make look lower than it actually is. To illustrate these techniques, we're going to use a real life firm, taking the name off, in this case it's a non-US firm, multinational, in the pharmaceutical business. Because it's a non-US firm, it uses international accounting standards not US gap. For the most part, we're going to see this in the presentation of the assets. They're going to show current assets and long term assets in a different order than a US firm would. We will see though that all of the monetary amounts are expressed in US dollars, so at least that will be familiar relative to a US company. This is a company that just repelled a major hostile takeover attempt, and actually just made a large acquisition as well. So, let's start by just taking a look at its income statement, balance sheet and cash flow statement, make some initial observations, and then start to do more in-depth analysis. So, let's start with the income statement. We can see that the top line, sales revenue is relatively flat, but the bottom line income number is decreasing quite rapidly. So, profitability is falling a lot. It's positive, but falling. On the balance sheet, we see assets are getting bigger so the firm is growing. On the other side of the balance sheet, we see how it's being funded. Liabilities are going up, but equity is going down. So, the mix of debt to equity is changing significantly. On the cash flow statement, the operating section of the cash flow statement, the numbers are positive. The firm is generating positive cash from operations and it's big enough in each year to fund all of their investing activities. Their investing activities increased a lot this most recent year, that's an acquisition that they made. And we see that their financing cash flows are negative. So, they're spending money, returning it to investors, mostly in the form of dividends. And in fact the dividends the last two years were bigger than the income that they generated. That's not that common and generally not that good a sign as well. So, let's look in more depth at some common types of ratios, first of all that relate to the issue of liquidity. That is, what's the risk that we're not going to be able to satisfy our obligations? What's the risk that we're going to run out of cash? Here, time frame is important. There were short term liquidity measures and long term liquidity measures. Whichever time frame we're using, we want to think about what are our obligations do within that time frame and what resources that we have available to satisfy those obligations? The ratio of resources we have relative to the obligations is in some sense our margin of safety. So, a bigger margin of safety obviously is less risky than a smaller one. So, let's start with short term liquidity measures that were commonly calculated, using balance sheet information. So short term liquidity measures means we're talking about obligations due within the next year. These are our current liabilities. So a natural benchmark for our current liabilities would be current assets. Those are both expected to resolve themselves within the next year. So the ratio of current assets to current liabilities is called the current ratio, and this is a very popular and very useful measure of short term liquidity. Analysts often have some concern though about whether or not all the current assets are that easily turned into cash. So, a more stringent measure would look at only the assets in the current section that are easily turned to cash. These are referred to as the quick assets. Now, here you've got to use some judgment to decide in this case which assets are quick and which assets are not. Often marketable securities or accounts receivable in addition to the cash itself, would be considered as part of the quick assets. So, for our case company, we can for each of the last three years calculate from the balance sheet, current assets and current liabilities, and take the ratio. Or just the cash plus receivables, the quick assets relative to current liabilities, and take the ratio as well and these are those numbers. As we can see, the margin of safety is falling in each year. So that's consistent with the risk or liquidity risk going up. These ratios are also lower than peer group firms. So that's also consistent with this firm starting to run into potential liquidity issues. Now let's look at it in a slightly different way. Another way to think about margin of safety is, can you cover the outflows that you're obligated to make this year? So, a common measure here would be, what interest do you have to pay this year? And you might think about the inflows coming in as representing the operating profit or the earnings before interest and taxes. This ratio is a common one and it's referred to as the Times Interest Earned Ratio. That is, how many times can you cover your interest expense with your earnings as you're reporting it today? Another common one, especially popular in startups, especially when we're not generating revenues yet, is called the Cash Burn Rate. This basically looks at the cash balance, and our rate of expenditures to see how long we can keep operating at this rate before we run out of cash and we need a new infusion of capital? So, for our case company, the Times Interest Earned Ratio, we can get off of the income statement, the interest expense relative to the operating profit, and we can see that that's falling dramatically. In part, that's because interest expenses is going up and the fact that that's coupled with operating profit going down makes the ratio fall even more. So, much greater risk relative to back in the first year of not being able to cover our interest expense, times interest earned, a very popular ratio. Cash burn ratio, we said more popular and applicable with respect to startup firms doesn't really apply here because we're not burning cash, we're actually generating cash from operations. Now let's turn to longer term risk ratios. Here we look at all of your debt or all of your liabilities. And a common benchmark here is your total assets or perhaps your stockholders' equity. Since stockholders' equity plus debt equals total assets, doing it one way versus the other are going to give you similar inferences but the numbers you're going to get will be different. And so again, it's important to keep straight which way are we calculating things. The idea here is debt requires fixed payments that if you don't make you'll go into default. Equity doesn't require those. So, capital supplied by equity acts as a buffer to shield you from losses and still be able to make the payments on your debt. Debt to equity ratios or variance thereof are very commonly used measures of financial distress. So, here for our case firm, we've calculated total liabilities to stockholders' equity and the total assets, and also just the long term liabilities relative to those measures as well. We can see that all of these ratios are getting bigger. That means the relative amount of debt relative to equity, or the relative amount of debt relative total assets is getting bigger. That means that there's less buffer to cover downturns and this is consistent with the company being riskier over time relative to what it was a couple of years ago. So, our overall picture is a company that's not doing that great, profits are down, debt is up, risk is up. We'll continue our analysis then with future videos.

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